Fear is the
greatest buy signal ever seen in the stock markets. This
overpowering emotion flares fast, driving excessive selling that
rapidly hammers stock prices down to irrational oversold levels.
These fear-driven lows are the ideal time for investors and
speculators to buy low, necessary before selling high later.
Provocatively stock fear has an effective ceiling, absolute
levels that demand aggressive buying.

I mentioned this
stock fear ceiling in passing a couple weeks ago in my latest essay
on trading stock
fear. I heard from a surprising number of traders interested in
this concept, for good reason. If stock fear has a ceiling, it
would flag the highest-probability-for-success buying opportunities
ever seen. Whenever this ceiling was hit in the future, it
would be the ultimate signal to boldly deploy capital regardless of
events.

While fear is
ethereal and canít be measured directly, plenty of sentiment
indicators infer it. The most popular by far is the famous VIX
(pronounced ďvicksĒ). Discussed often in the financial media, this
measures the implied volatility of certain S&P 500 index
options. The S&P 500 (SPX) is Americaís flagship stock index
tracking this nationís biggest and best companies, and the best
proxy for the stock markets as a whole.

The VIX uses
complex formulas to analyze and weight SPX options prices expiring
over the next 30 calendar days. Traders are constantly buying and
selling options based on their own near-future outlook, which bids
up or drives down specific optionsí prices. The aggregate of all
this short-term SPX options trading is distilled down into implied
volatility, or how volatile options traders as a group expect
the stock markets to be.

The VIX expresses
this construct as an annualized percentage. A 20 VIX reading
implies that options traders expect to see the SPX move up or down
at an annualized rate of 20% over the next 30 calendar days. Since
fear is a far-more immediate and powerful motivator than greed,
options volatility soars after major selloffs (the time to buy low)
before waning to insignificance after major rallies (the time to
sell high).

Despite the VIXís
popularity, it is a watered-down usurper. Todayís VIX was created
in September 2003 to replace the classic VIX, which is now known
as the VXO. That original VIX only looked at options for the
elite S&P 100, the top 20% of S&P 500 companies. And it only used
at-the-money options. While this methodology lives on in the
VXO, the new VIX changed how it is calculated. Todayís VIX
considers options for the entire S&P 500, including out-of-the-money
ones. This makes it less responsive to fear.

This is a problem
for a fear gauge. During sharp selloffs that spark intense
fear, the first stocks to be sold are the biggest and most-liquid
ones. They have the large volumes and liquidity necessary to absorb
the widespread exodus of capital without suffering anywhere near as
much price damage as smaller less-liquid companies. And
at-the-money optionsí prices are always quicker to respond (with
bigger moves) than out-of-the-money ones. So while the new VIX
works, the classic VXO remains superior.

Fear shows up
quickest and largest in at-the-money options representing the
largest and most-liquid companies in the US stock markets. Thus I
continue to use the original classic-formula VIX, now known as the
VXO, in my stock-market-sentiment research. If you prefer the
new-formula VIX, it would still lead to the same conclusions. A
less-responsive thermometer still gives you the temperature. But
with its history only extending back to 2003, its track record pales
in comparison to the VXOís since 1986.

As the
classic fear gauge, the VXO is the best sentiment indicator to flesh
out the concept of a fear ceiling in the stock markets. This first
chart shows the SPX superimposed over the VXO since 1996. While the
VXOís history extends back a decade earlier, there was only one
major fear spike in that entire span. So the past 15 years out of
the last quarter-century are the relevant ones to illustrate the
fear ceiling.

And these 15 years
have been extraordinary indeed! They witnessed the once-in-34-years
transition from secular bull to secular bear in early 2000 as the
Long Valuation
Wave crest passed. They saw three cyclical bulls alternating
with two cyclical bears within these longer secular trends. They
encompassed booms and busts, a popular tech-stock mania and a stock
panic, sovereign-debt defaults and currency routs, wars and
political turmoil, unprecedented terrorist attacks, and every kind
of disruption under the sun. Itís hard to imagine a more extreme
15-year period!

Yet despite all
this, with one notable exception Iíll get to later the VXO never
materially exceeded 50. A 50ish VXO is the absolute fear ceiling
of the stock markets in normal conditions, meaning times when
an ultra-rare panic or crash is not upon us. At every single one of
these 50ish approaches in the past 15 years, traders were utterly
terrified, convinced the stock markets were thundering off a cliff.
Yet fear still didnít surge any higher, I suspect it couldnít.
VXO 50 is the effective limit.

When you think
back to some of these events that spawned extreme fear, like August
1998ís Russian debt default or the September 2001 terrorist attacks
in the US, itís hard to imagine anything scarier. These events and
several others galvanized the whole world, sparking extraordinary
anxiety and fear. Other than ridiculous scenarios like global
thermonuclear war or an alien invasion, itís hard to imagine traders
worldwide being any more frightened.

Yet the VXO still
peaked near 50 consistently. A 50 VXO means the
annualized change options traders expected in the stock markets
over the coming calendar month was 50%! At VXO 50 options traders
believe there is a one-standard-deviation chance (68%) that the S&P
100 (and broader SPX) will either soar or plunge at a 50% annualized
rate over the next 30 days. This obviously isnít sustainable.

Whenever traders
are terrified enough to expect such gigantic moves, which only
happens after extreme selloffs, the selling has already passed.
Fear works this way in general too, with its maximum levels
happening just as the threat is gone. In a haunted house for
example, it is anticipation that builds fear. Once the actor
with the bloody mask and chainsaw jumps out and screams at you, peak
fear has already passed. When options traders expect the worst is
exactly when the worst has just been seen.

Yes, stock panics
and crashes like 2008ís and 1987ís see fear soar to a whole new
level and shatter the VXO 50 ceiling shown above. But these events
are exceedingly rare, and only happen at very specific times in the
bull-bear cycles.
They are essentially once-in-a-generation fear super-spikes.
In normal market conditions that arenít panics and crashes, 99%+ of
the time, VXO 50ish is fearís absolute ceiling.

The stock markets
can be viewed as an endless sentiment wave oscillating between
extreme fear and extreme greed. If you want to buy low and sell
high, you have to ďbe brave when others are afraid, and afraid when
others are braveĒ as legendary contrarian investor Warren Buffett
put it. This means buying when everyone else is scared (high VXO),
and selling when everyone else is greedy (low VXO).

The next two
charts zoom in to show all the VXO 50 episodes of the past 15 years
in more detail. Since fear mushrooming extreme enough to slam into
this absolute ceiling is pretty rare, I also considered lesser fear
spikes running from roughly VXO 40 to VXO 50. This is the
high-probability bottoming zone all investors and speculators should
welcome with open arms.

Every VXO closing
high is labeled, along with the number of days it is offset from the
actual bottom in the SPX. Normally this is zero, VXO highs occur
exactly on major SPX lows. But sometimes the stock markets will
grind along and take a week or two to bottom, slumping to a
slightly-lower secondary low after fear is already bleeding off. In
addition, the best SPX gains seen within the immediate
subsequent one-month and two-month periods following each VXO high
are noted.

As you can see,
buying fear spikes is incredibly profitable. It doesnít
matter whether the stock markets happen to be in a secular or
cyclical bull or bear, they always rally sharply after fear
grows too extreme. The excessive fear forces stock prices to be
battered down to irrational oversold levels, so as that
unsustainable fear inevitably abates stocks soar as capital floods
back in. The gains are huge!

This essay would
grow far too long if I analyzed every major VXO high in detail. But
take a look at the kinds of gains across all of them. On average
over this incredibly-chaotic span between 1997 and 2003, the SPX
soared 13.0% sometime within the first month after a VXO peak and
16.4% sometime within the first two. After extreme fear comes
extreme rallies, running as high as +19% within one month and +24%
within two!

These are not only
incredibly-large and fast gains, but they are in the broader
markets. Many investors and speculators prefer individual stocks in
leveraged sectors like commodities or technology. Since these
high-flying popular stocks are battered much lower during fear
spikes, they soar much faster coming out of them. Their gains often
double or triple those seen in the broader SPX. Buying great
commodities stocks during extreme fear spikes can easily yield 50%+
gains within a couple months!

Since these
awesome buying opportunities are rare, as the VXO doesnít often soar
into the 40s or hit its 50 ceiling, contrarian investors and
speculators shouldnít hesitate to capitalize on them. The higher
the VXO gets, the more cash (raised from selling high near the
preceding interim top) should be immediately plowed into
high-potential stocks you want to own. Since these fear spikes are
fleeting, this stock
research into what to buy must be done well before the
short-lived when to buy arrives.

While 1997 to 2003
may seem like irrelevant ancient history to some, it is crucial in
establishing the importance of the VXO 50 fear ceiling in normal
market conditions. This next chart extends this analysis to the
modern period of big fear spikes running from 2008 to 2011. While
2008ís
once-in-a-century stock panic was an obvious exception, outside
of it the VXOís high-odds bottoming zone held strong.

2008ís ultra-rare
stock panic drove a fear super-spike the likes of which hadnít been
seen since the last extreme selling event in October 1987. On
October 19th, 1987 the stock markets crashed with the SPX
plummeting an unbelievable 20.5% in a single trading day!
This blasted the VXO from its prior-day close of 36.4 straight up to
its all-time high of 150.2! Actual crashes easily shatter the
normal stock fear ceiling.

After that the VXO
never even came close to breaking out above 50 again until October
2008, fully 21 years later. During another crazy-brutal
selloff over a two-week period ending October 10th, the SPX plunged
25.9%! This drove a VXO super-spike to 86.0, and a secondary
selloff 6 weeks later once again pushed the VXO up to its panic peak
of 87.2! Panics also easily rocket above the VXO 50 ceiling.

But this certainly
doesnít mean a panic or crash should be expected every time the VXO
nears 50, far from it. These extreme selling events are exceedingly
rare, so expecting them is usually irrational. On one terrible day
in US history, terrorists hijacked airplanes and flew them into
skyscrapers. So every time a jet is seen in the sky, should
skyscrapers be evacuated? Ultra-low-probability events shouldnít be
weighted highly.

In our entire
lifetimes, we have only seen a single stock panic and a single stock
crash. Even in the past century, there have only been a
couple of each! The panics were in 1907 and 2008 while the crashes
were in 1929 and 1987. These events are exceedingly rare because it
takes decades for complacency to grow extreme enough to fuel
such massive fear blowouts. They are once-in-a-generation
occurrences. Expecting another panic or crash soon after the last
one is like expecting another massive wildfire in an area recently
burned out by one. It canít happen because there isnít sufficient
time for enough new fuel to grow back in.

Panics are 20%+
plunges in the stock markets within a couple weeks, while
crashes are 20%+ plummets within a couple days. Panics only
cascade out of lows deep and late in cyclical bears, representing
the capitulation selling climax of those bears. Crashes only erupt
from multi-year highs at the ends of 17-year secular bulls. If it
hasnít been decades since the last panic or crash, and the stock
markets are not in the right place in their
bull-bear cycles
to spawn them, they arenít going to happen. They are irrelevant for
fear-ceiling purposes unless the stock cycles are favorable for one,
which isnít often.

Since 2008ís panic
there was one major fear spike last summer, but it was sloppy. A
variety of crosscurrents dragged the SPX to a secondary low after
the initial VXO peak, which moderated the immediate gains
considerably. But even if you had bought stocks in that early fear
spike as we did, the resulting gains over the next 6 months were
huge as the SPX belatedly rallied as expected. Many of our
commodities-stock trades added during summer 2010ís fear spikes were
realized last winter at 100%+ annualized gains!

And all this
brings us to this monthís massive fear spike, where the VXO
rocketed near 50 for the first time since the stock panic! Not
coincidentally, this happened to be during the second correction of
this SPX cyclical bull. Traders have been terrified in
recent weeks, utterly convinced that European sovereign debt, or
European banks, or Obamaís out-of-control spending, or the resulting
USA debt downgrade are going to soon push the US stock markets over
a cliff. Fear has been incredibly intense.

But fear was
equally intense during all the VXO 50 spikes in the past quarter
century as well, yet the markets still rallied dramatically.
Each time the VXO slammed into its effective ceiling in normal
market conditions, the SPX rallied sharply soon after. Such extreme
fear forces everyone susceptible to being scared into selling
anytime soon into dumping their positions immediately. This soon
exhausts all available selling pressure leaving only buyers, who
soon ignite the massive and sharp post-fear rallies.

Fundamentals are
irrelevant when fear peaks, things always look the worst
after the stock markets have fallen hard. Sharp stock-market
selloffs lead to a bearish selection bias among the financial media
and traders, they choose to dwell on the most-pessimistic
stories they can find while ignoring any positive ones. After being
hyper-oversold in a major fear spike, capital floods back into
stocks no matter what is going on fundamentally in the global
economy at large. Bull or bear, recession or not, it doesnít
matter!

I started my own
research into VXO spikes way back in the
summer of 2002,
and have been well aware of the VXO 50 ceiling ever since. We
bought aggressively each time it was seen, and recommended our
subscribers do the same. Theyíve earned fortunes by steeling
themselves to buy low when everyone else was scared and then later
sell high when everyone else was greedy. We bought aggressively
during 2008ís stock panic too, even though I hadnít anticipated an
ultra-rare VXO super-spike. Their great rarity makes them
inherently unpredictable. It didnít matter though, the subsequent
gains were still enormous the following year. Excessive fear must be bought!

Extreme fear flags
the best buying opportunities ever seen, the lowest stock prices
possible. And VXO 50 is as high as fear gets the vast, vast
majority of the time. So when this latest VXO 50 spike emerged in
early August, needless to say we started buying aggressively. In
our popular Zeal
Speculator weekly newsletter, weíve added 13 new stock trades
and 6 new options trades in August alone! I fully expect these to
soar to massive gains over the coming months as the stock markets
inevitably recover.

While buying fear
isnít easy psychologically, it is necessary if you want to
buy low. Fighting the crowd yields amazing gains over time. Since
2001, during a tough sideways-grinding secular stock bear, all 591
stock trades
recommended in our newsletters have averaged annualized realized
gains of +51%! We didnít achieve this by buying high when it felt
good and selling low when everyone was scared, but by doing the
exact opposite. If you want to thrive in the stock markets,
subscribe today
to our acclaimed
weekly or
monthly newsletters! Learn how to see the markets and trade
them like a contrarian.

The bottom line is
stock fear has a ceiling, and that is represented by a 50ish VXO.
While this ceiling wonít hold during panics and crashes, those
ultra-rare once-in-a-generation events arenít worth worrying about
the vast majority of the time. Normally whenever the VXO surges to
50, it is time to buy aggressively as fear has peaked so a huge
stock-market rally is imminent. This is true in secular and
cyclical bulls and bears alike.

And just a few
weeks ago, the VXO once again slammed into this effective ceiling.
Fear was incredibly intense, with perma-bears, chicken littles, and
pessimists coming out of the woodwork to call for a continuing stock
plunge. But market history clearly shows that expecting the stock
markets to head lower after a fear-ceiling approach is almost never
the right bet to make. Extreme fear should always be bought!